FISCAL POLICY AND TAXATION:Budget Deficit, Budget Surplus and Balanced Budget

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Introduction to Economics ECO401

UNIT - 12

Lesson 12.1

FISCAL POLICY AND TAXATION

Fiscal policy is the government's program with respect to the amount and composition of (i)

expenditure: the purchase of goods and services, and spending in the form of subsidies,

interest payments on debt, unemployment benefit, pension and other payments, (ii) revenues,

i.e. taxes and non-tax fees (such as license fees etc.) and (iii) public debt: borrowing to cover

the excess of expenditure over revenues. Borrowing can be done from three sources:

domestic banks and the general public, the central bank (e.g. State Bank of Pakistan), and

foreign creditors.

Budget Deficit, Budget Surplus and Balanced Budget:

If i>ii: the government is said to be running a fiscal or budget deficit and so the government

must borrow (or raise debt) to cover the deficit; if i<ii: the government is said to be running a

fiscal or budget surplus and so the government can pay-off or reduce its debt; if i=ii: the

government is said to be running a balanced budget and the government's net debt may

remain constant.

Fiscal deficits and debt are often reported as a ratio of GDP. Although, there is no theoretical

benchmark for what constitutes a sustainable fiscal deficit or public debt ratio, the Maastricht

criteria (for countries in the European Union) is an important practical guide. It stipulates that

fiscal deficit to GDP should be less than 3% while public debt to GDP should be less than

60%.

The Concept of Taxation:

Taxes are general purpose, compulsory contributions by the people to the public treasury (or

national exchequer) to meet the expenditure needs of the government. Without taxes, the

government would not be able to deliver services like law and order, public administration,

national defense, free or subsidized health and education etc.

Since taxes interfere with the market mechanism, they are considered distortionary, and as

such there is a long-standing debate over the desirability of taxes. In a way, the stance over

taxation defines the economic "right" and "left" in HICs. The market-friendly right (like the

Republicans in the U.S. or the Conservatives in the U.K.) believe in reducing the size of the

government and its spending so that most of the services in the economy are provided by the

private sector. As such they can argue for lowering taxes (since government spending is also

less) which according to them distort private sector incentives (remember the Monetarist

argument for removing income taxes in the context of unemployment). By contrast, the

interventionist left (like the Democrats in the U.S. or the Labour in the U.K.) consider that a big

and active government essential for the delivery of better public services and therefore are

often against cutting taxes and transferring the responsibility of providing these services to the

private sector.

The Debate over Taxation:

There are two dimensions to the debate over taxation: equity and efficiency.

The Concept of Equity:

Equity represents that principle of taxation which emphasizes fairness or just sacrifice, i.e.

everyone should pay tax according to his/her ability. So if a person earns higher income, s/he

should be subjected to a higher tax rate. Thus, for e.g., a person earning Rs. 2,000 a month

should sacrifice 10% of his/her income as taxes (i.e. Rs.200), whereas a person earning Rs.

200,000 should sacrifice 60% of his/her income as taxes (i.e. Rs. 120,000). In the absence of

such progressive taxation, the rich person would have also paid a 10% income tax rate (i.e.

Rs. 20,000). Progressive taxation, in which the tax rate increases as income increases, is an

application of the vertical equity principle which espouses the Robinhood approach of taking

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money from the rich and distributing it to the poor. While controversial, the vertical equity

principle in taxation is applied in one way or another in most countries across the world.

Horizontal Equity:

A less controversial principle relates to horizontal equity which says: identically well-off people

should be taxed identically, i.e. no discrimination due to race, gender, caste, religion etc. There

are many examples, however, of violation of this principle and often one comes across an

individual belonging to a certain community or grouping enjoying certain economic privileges

not enjoyed by a similarly endowed individual of another community or grouping.

We now turn to the efficiency dimension, which concerns the distortionary effects of taxation,

esp. the possible negative effects on private sector behaviour and incentives. The more

distortionary a tax, the higher the efficiency concerns surrounding it.

The Concept of Efficiency:

To illustrate the concept of efficiency, it is useful to develop an understanding of what is meant

by a Pareto-efficient allocation of economic resources. This is a situation in which it is

impossible to move to another allocation which would make some people better off and

nobody worse off. In the context of the production possibilities frontier, therefore, points on the

frontier are all Pareto-efficient, as it is not possible to move to another point (i.e. produce more

of one good) without incurring some opportunity cost (i.e. sacrificing the production of some

other good).

Economists argue that a free-market perfect competitively economy where P=MC

automatically delivers the optimal allocation in the economy (Pareto-efficiency), so any

government intervention (like tax) that interferes with that allocation generates efficiency

losses. The efficiency (or welfare) loss of a tax can be illustrated by a simple demand supply

diagram. It can be seen that the loss in consumer and producer surplus is greater than the

revenue gain to government.

Does the above argument mean a tax can never be justified on efficiency grounds?

No. There are two cases in which imposing a tax may actually be better than not imposing it.

i. When there are market failures, and a tax is imposed to bring the marginal social

cost equal to marginal social benefit.

ii. When there are existing distortions in the economy and taxes are imposed to

spread the distortion over many commodities rather than placing the burden on

just one commodity. Another way to say it is: it is better to impose a small tax on

a number of commodities to raise a certain amount of government revenue,

rather than impose one large tax on one or two commodities only.

Types of Taxes Which a Government Can Impose:

With the theory of taxation covered, we can now move to the actual menu of taxes the

government can impose to raise revenue for itself.

i. Direct taxes, like income tax, which is imposed on factor incomes. Income tax for

individuals is called personal income tax, while for firms is called corporate

income tax.

ii. Indirect taxes, like sales tax or value added tax, which is imposed on expenditure

on goods and services

iii. Tariffs which and are imposed on import expenditure

iv. Wealth or property taxes which are imposed on fixed assets.

For LICs, income tax collection is very low and indirect taxes often account for more than 2/3rd

of total revenue as citizens often under-report their incomes in these countries, there is no

voluntary tax payment culture, and income tax collection agencies are weak and/or corrupt. By

contrast, for HICs, income taxes are much more important, accounting for over 2/3rd of total tax

revenue.

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Disposable income is obtained by subtracting income tax from total income. At the national

level, disposable income Yd is calculated as Y-T, or Y-tY, where t is the net income tax rate.

One important question before governments is determining the optimal tax rate, t, for the

average citizen. If t is too low, not enough taxes might be collected to enable the government

to run and provide proper services. If t becomes too high, the incentive for citizens to work will

be reduced, meaning national income will go down and tax collection will fall. Also at very high

levels of t, the incentive to cheat and evade taxes increases and the government, therefore,

might face serious enforcement problems.

The Laffer curve:

The relationship between tax rate and tax revenue collection can be summarized in the Laffer

curve diagram. In the tax revenue-tax rate space, the Laffer curve plots as an "inverted U",

delivering an optimal tax rate t* which is less than 100%.

Expenditures and the Effects of Fiscal Policy:

Having concluded the discussion on tax policy and taxation, let us now focus on expenditures

and the effects of fiscal policy in aggregate.

Expenditures may be categorized as recurrent and development. The former includes interest

payments on debt, salaries and administrative expenses of all government ministries and

departments, and other exigent recurrent charges on the exchequer. The latter mainly social

sector capital expenditures, esp. those which are expected to yield long-term development

benefits. Examples are building a school or hospital, laying down a new railway system,

building a motorway etc.

Governments often promise to undertake heavy development and social sector (i.e. health,

education etc.) expenditures, but due to scarcity of revenues and borrowing possibilities, can

only manage small development expenditures. A large part of the budget in most countries is

committed to recurrent charges.

Repayment of debt is reported below the line with other borrowing and debt aggregates, as it

is neither strictly recurrent nor development spending.

Revenues (recurrent + development expenditures) + interest payments on debt] gives the

primary surplus, i.e. the amount available to service the burden of public debt.

The tax-adjusted Multiplier and the Balanced budget Multiplier:

Taxes act as a drag on the multiplier effect of government spending, since they represent a

leakage from the circular flow of incomes. The tax-adjusted multiplier k* is smaller than the

basic Keynesian multiplier, k, introduced earlier. k* is given by {1/[1-(MPC)(1-t)]}, where t is net

income tax rate, and T = tY. The higher the tax rate, the greater the leakage and the smaller

the fiscal policy multiplier.

It is interesting to consider the special case of balance budget multiplier. The concept here is

that if the government spends Rs.10 bn and finances it by increasing taxes by Rs. 10 bn, the

multiplier will not be zero, as one might initially expect. This is because, the higher tax causes

disposable income to fall, which in turn causes saving and imports (the other two types of

leakages) to fall. Thus the net leakage from the system is less than Rs. 10 and there is a

positive multiplier effect, albeit small.

Financing of Deficit:

Since the size of the balanced budget multiplier is small, it is not always possible to get the

required demand expansion by raising expenditures and taxes symmetrically. Thus, the case

of deficit spending and financing must be considered. Here the government spends more than

its revenues, and raises debt to finance the excess of expenditures over revenues. The three

borrowing options were mentioned earlier:

i. Borrow from domestic banking system or general public through a sale of

treasury bills and bonds. Bills are short-term debt instruments (< 1 year) and

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bonds are long-term bond instruments (> 2 years).4 The major disadvantage of

this type of borrowing is that it can lead to crowding out of private sector activity.

How? Consider the market for loan able funds. An increased demand for funds by

the government will cause interest rates in the economy to rise (making loans

more expensive for everybody, including the private sector) as well squeeze the

quantity of credit available for lending to the private sector.

ii. Borrow from the central bank by ordering the latter to print money and lend it to

the government (free or at an interest cost) for onward spending. All governments

would love to do this, except that this type of "apparently free" financing is highly

inflationary. You can easily imagine why. An increased supply of money given a

fixed supply of gods will naturally cause prices of those limited goods to rise.

iii. Borrow from foreign sources either through bonds floated on international capital

markets or bilateral, multilateral or commercial loans. The advantage of this type

of borrowing is that it does not lead to crowding out and is not immediately

inflationary, especially if some of the loan helps finance import expenditure. If all

the borrowed money is spent locally given a fixed exchange rate, the monetary

effects of foreign borrowing might become very similar to those of borrowing from

the central bank.

Should the Fiscal Policy be Active or Passive?

In view of the above complications, there is a long-standing debate on whether fiscal policy

should be active or passive. Note that in a Keynesian context, even a passive fiscal stance will

produce an automatic stabilizer effect on aggregate demand. How? If AD falls, Y falls, tax

collection falls, the net income tax rate falls, which is equivalent to a passive fiscal policy

expansion. Also, when AD and Y fall, unemployment rises; which means more people become

eligible for unemployment benefit, which in turn causes government expenditure to rise, which

is again equivalent to a passive fiscal policy expansion. It is easy to derive the reverse

situation: in which AD rises and fiscal policy becomes passively contractionary.

In addition to the above, there is an argument that active fiscal policy cannot be changed

without a time lag. The government passes its budget on an annual basis, and thus a mid-year

change in AD which warrants a fiscal policy response must wait till the start of the next fiscal

year. Unfortunately, the demand conditions might have changed by that time!

Other arguments against active fiscal policy-led demand-management include the

effects of a fiscal expansion on interest rates and subsequently the exchange rate. As

mentioned in the discussion on BOPs, a rising domestic interest rate will cause the

exchange rate to appreciate in real terms (due to the interest parity condition). This,

however, will cause competitiveness to decline will drive down exports and lead to

BOPs problems.

Finally, expansionary fiscal policies can raise the national debt (as you know, national

debt is simply an accumulation of past fiscal deficits) which would have to be paid off

by future generations, possibly through a painful increase in their tax contributions.

Bills and bonds can be thought of as certificates that the government gives to its lenders in exchange for cash.

The terms on the certificate stipulate when the government will repay the cash and what interest rate it will pay till

maturity. Thus if the government sells you a 10% 10-year Wapda bond worth Rs. 1000 today, it means you will

give the government Rs. 1000 today and receive the Rs. 1000 from government after a period of 10 years. In the

meantime, however, the government will pay you interest at 10% (or Rs. 100 per year).

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END OF UNIT 12 - EXERCISES

If tax increases are `phased in' as the economy recovers from recession, how will this

affect the magnitude and timing of the recovery?

It would have a similar effect to automatic fiscal stabilisers. It would reduce the rate of growth of

aggregate demand and thus dampen and slow down the recovery. The hope of the government

was that this would make the recovery more sustainable and would create confidence in the

financial community that the budget deficit would be significantly reduced over the longer term.

As the budget deficit fell, so the hope was that this would allow interest rates to fall. The danger,

of course, was that the tax increases might totally halt the fragile recovery.

At lot depended on confidence. The more that investors believed that the policy would help to

make the recovery more sustainable, the more they would invest and, therefore, the more

sustained the recovery would be. On the other hand, if investors believed that the tax increases

would kill off the recovery, the less they would invest, and therefore the more likely the recovery

would peter out.

If tax cuts are largely saved, should an expansionary fiscal policy be confined to

increases in government spending?

Ricardian equivalence states that when a governemnt cuts taxes (and finances the resulting

fiscal deficit from borrowing), taxpayers will not spend the higher disposable incomes they are

left with as a result of the lower taxes, because they will expect government to raise taxes in the

future in order to pay the higher interest cost of debt incurred today. Under these conditions,

increases in government spending, provided they are direct expenditure on output-generating

activities, will be more effective than tax cuts in stimulating the economy.

Could you drive the car at a steady speed if you knew that all the hills were the same

length and height and if there were a constant 30-second delay on the pedals?

Yes. You would simply push on the accelerator (or brake) 30 seconds before you wanted the

effect to occur. You would do this so that the car would end up braking as you went down hill

and accelerating as you went up hill.

The lesson for fiscal policy is that if forecasting is correct, if you know the precise effects of any

fiscal measures, and if there are no random shocks, then fiscal policy can stabilise the economy.

How can a government finance its fiscal deficit?

By borrowing locally (i.e. issuing bonds), foreign financing (including non-relpayable grants) or

printing money (i.e. borrowing from the central bank). The first of these methods is least

inflationary while the last one is most inflationary.

Are all taxes distortionary?

A naïve but not incorrect answer is "Yes". Indeed all taxes are distortionary, "but", given existing

distortions, imposing some taxes can actually reduce the distortion in the economy. This is the

theory of the second best.

Why is the "without tax" multiplier smaller than the "with tax" multiplier?

Because taxes are a leakage from the circular flow, and the multiplier measures the impact of an

injection onto the circulr flow. The more avenues for leakages, the less will be this impact.

How is a sales tax different from a graduated income tax?

The sales tax is a direct and progresisve tax. It's direct because it is a deduction from the net

income of an individual. It is progressive because the graduated levy ensures the burden of tax

reduces for poorer people (this is consistent with the equity principle that the tax burden should

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be commnsurate with "ability to pay"). A sales tax is an indirect tax because it indirectly taxes

people's incomes. What it taxes directly is people's consumption expenditure. Naturally, the

sales tax is regressive; a poor person pays the same percentage of the retail price as tax as a

rich person.

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